Financial Market Commentary

In this column I will continue the theme of quoting Washington’s Farewell Address, this time on the topic of national unity and political partisanship. First, a summary of Washington’s thoughts on the importance of national unity and how to remain on guard against those who would compromise it, followed by an exact quotation of his own words.

1. Unity of government is important to the citizens of the United States because unity supports our independence, peace, safety, prosperity and liberty.
2. I can foresee, however, that many will employ mistruths, often covertly and indisiously, to weaken our conviction to preserving national unity.
3. It is of the utmost importance that we properly estimate the value of our national union, and develop the unwavering habit of preserving it; moreover, our collective efforts to do so should always be cordial.
4. We should disapprove of — to the point of embarrassing — those who would even suggest national unity is not necessary, or that any portion of our country or its citizens can be alienated from the rest.
5. Some will attempt to undermine our national unity by misrepresenting the opinions and goals of others; this is something from which you cannot shield yourself too much, as these mispresentations will make us feel alien to one another, when instead we should be fostering feelings of fraternal affection.
6. The alternate domination of one party over another, especially when sharpened by the spirit of revenge, is itself a frightful form of despotism, which gradually leads to a more formal and permanent despotism.
7. This despotism leads citizens to seek security by granting individuals absolute power; but leaders who would accept such power are only interested in elevating themselves at the expense of public liberty.

The exact quotations from Washington’s Farewell Address follow below:

The unity of government which constitutes you one people is also now dear to you. It is justly so, for it is a main pillar in the edifice of your real independence, the support of your tranquility at home, your peace abroad; of your safety; of your prosperity; of that very liberty which you so highly prize. But as it is easy to foresee that, from different causes and from different quarters, much pains will be taken, many artifices employed to weaken in your minds the conviction of this truth; as this is the point in your political fortress against which the batteries of internal and external enemies will be most constantly and actively (though often covertly and insidiously) directed, it is of infinite moment that you should properly estimate the immense value of your national union to your collective and individual happiness; that you should cherish a cordial, habitual, and immovable attachment to it; accustoming yourselves to think and speak of it as of the palladium of your political safety and prosperity; watching for its preservation with jealous anxiety; discountenancing whatever may suggest even a suspicion that it can in any event be abandoned; and indignantly frowning upon the first dawning of every attempt to alienate any portion of our country from the rest, or to enfeeble the sacred ties which now link together the various parts.

In contemplating the causes which may disturb our Union, it occurs as matter of serious concern that any ground should have been furnished for characterizing parties by geographical discriminations, Northern and Southern, Atlantic and Western; whence designing men may endeavor to excite a belief that there is a real difference of local interests and views. One of the expedients of party to acquire influence within particular districts is to misrepresent the opinions and aims of other districts. You cannot shield yourselves too much against the jealousies and heartburnings which spring from these misrepresentations; they tend to render alien to each other those who ought to be bound together by fraternal affection.

The alternate domination of one faction over another, sharpened by the spirit of revenge, natural to party dissension, which in different ages and countries has perpetrated the most horrid enormities, is itself a frightful despotism. But this leads at length to a more formal and permanent despotism. The disorders and miseries which result gradually incline the minds of men to seek security and repose in the absolute power of an individual; and sooner or later the chief of some prevailing faction, more able or more fortunate than his competitors, turns this disposition to the purposes of his own elevation, on the ruins of public liberty.

Jeremy Grantham’s missives are always must-reads, and his most recent “I Like Ike: A Powerful Warning Ignored,” is no exception (download from gmo.com with free registration, or Zero Hedge without registration).

For those of you who found Grantham’s review of Eisenhower’s warnings to our country interesting, I thought you might also enjoy a quick tour through some of the writings of the ultimate founding father: George Washington. Given that our current Congress has such an interest in our founding fathers’ intentions — exemplified by their reading the Constitution in their first session of the year — I suggest that they also read Washington’s Farewell Address (1796) out loud one of these days, as it contains additional advice our political leaders would undoubtedly find useful, given our country’s current circumstances.

For those of you who in a hurry, here’s a synopsis of Washington’s advice on credit and taxation:

1. Use credit as sparingly as possible.
2. Cultivate peace, but when absolutely necessary, it’s permissible to borrow to defend the nation.
3. Work vigorously during peace time to retire any debt that accumulated during war.
4. Don’t expect the next generation to pick up the tab.
5. It’s the responsibility of both elected representatives and the general public to reinforce these principles.
6. Taxes are always inconvenient and unpleasant, but the public should cooperate when raising additional revenue through higher taxes becomes temporarily necessary.

For you fact-checkers out there, here are President Washington’s own words regarding credit and taxation:

As a very important source of strength and security, cherish public credit. One method of preserving it is to use it as sparingly as possible, avoiding occasions of expense by cultivating peace, but remembering also that timely disbursements to prepare for danger frequently prevent much greater disbursements to repel it, avoiding likewise the accumulation of debt, not only by shunning occasions of expense, but by vigorous exertion in time of peace to discharge the debts which unavoidable wars may have occasioned, not ungenerously throwing upon posterity the burden which we ourselves ought to bear. The execution of these maxims belongs to your representatives, but it is necessary that public opinion should cooperate. To facilitate to them the performance of their duty, it is essential that you should practically bear in mind that towards the payment of debts there must be revenue; that to have revenue there must be taxes; that no taxes can be devised which are not more or less inconvenient and unpleasant; that the intrinsic embarrassment, inseparable from the selection of the proper objects (which is always a choice of difficulties), ought to be a decisive motive for a candid construction of the conduct of the government in making it, and for a spirit of acquiescence in the measures for obtaining revenue, which the public exigencies may at any time dictate.

In my next post I will quote President Washington on the need to maintain national unity.

The recent Employment and Housing data have not provided confirmation for the surge in bullish sentiment observed in December (unless you read the extreme sentiment as a contrarian indicator). The market exhibited a delayed reaction to another well-known technical indicator this summer, and I believe that’s happening again in this case. 

I first made note of the market’s unusual exuberance in July (Stock Indexes Ignore Technicians’ Head and Shoulders Calls). I found it odd that the market was enjoying a rally, despite the fact that stock prices had just completed a classic head and shoulders pattern. Of course, the predicted correction arrived in the fall, with a delay. Here’s one case in which the head and shoulders signal was profitable — there was plenty of time to make adjustments to portfolios or hedge the expected decline in equities.

I believe the case can be made that the same type of delayed reaction to the extremely bullish sentiment from December (a classic market top signal) is developing now. Just a few weeks after the surge in positive sentiment, we received unequivocally bad reports on variables that will be key in 2011-2012: housing and employment.  The recent dip in the Case-Shiller Index:

 and weak additions to Total Non-Farm Payrolls:

simply confirmed that analysts and pundits are, once again, too bullish. Moreover, when you also consider the trend in the Core CPI:

the recent numbers are more consistent with the Fed’s deflation scenario.

Why should the market exhibit a delayed reaction again, this time to the extreme optimistic sentiment from December? Asset prices reflect a premium for the Bernanke and other de facto put options that remain in-the-money, at least for now. These mechanisms encourage excessive risk-taking, which results in expected returns getting bid gradually lower. Just look at commodities prices. The market is running on animal spirits. Investors and traders are out of the habit of even looking at data — the market’s been shrugging off bad news for almost 2 years now (see Cullen Roche’s classic post from December 27, Equity Valuations are Stretched — But Does it Matter?). Combined with Goldman Sach’s trotting out Abby Joseph Cohen to shout “Synchronized Global Boom” in crowded theaters, the market’s had every possible signal of a short-term top thrown in its face — and valuations will most likely correct sometime in the next month or two, exhibiting the same delayed reaction as we saw following the July head and shoulders pattern.

Regarding the Fed’s ongoing involvement in markets, businesspeople and bankers who are in the trenches continue to acknowledge that these government mechanisms have been, and unfortunately continue to be, necessary to obtain the level of financial stability and confidence necessary for economic growth. And there’s no shortage of regional and community bankers who are still plenty nervous.

It’s a little scary to think that much of what we’ve accomplished thus far amounts to merely substituting 1.) government guarantees, 2.) a massive transfer of bad paper from private to public balance sheets, and 3.) ongoing zero real interest rates for the leverage infused into the financial system in the previous decade. The various guarantees and Quantitative Easing programs are merely leverage substitutes, only some fictitious future US taxpayer is on the hook for the whole thing. The US economy and financial system are not ready to take off the training wheels.

Put another way, the multi-decade experiment of coming off the gold standard has led to a grotesque endgame: The Federal Reserve desperately propping up asset prices and throwing everything it’s got at the problem of creating inflation (a task at which it has been completely unsuccessful thus far). I find it more than a bit macabre that we’ve all casually accepted that the best thing for long-term national prosperity is to debase our currency as quickly and completely as possible. Someone tell me again how that makes sense — I keep forgetting.

Yet another thing I regret having to write, but needs to be written nonetheless: The recent data suggest that we might not want to pull back on all those Federal Reserve pro-liquidity programs just yet. It’s not so much that I’m motivated to give the Fed credit for getting anything right, I just think in this case we have more of an accidental matching of the right medicine and the right time. I’d like to see the economic data firm up a bit more, preferably in a recognizable trend, before the Fed changes course.